Why cash is best as your go-to guy

After reading my columns over the past month you’ve built yourself a well-diversified, multi-asset class portfolio. But you have this lingering sense of doubt.

Two residual questions snake through your mind. What is my bedrock, all-weather, all-terrain asset-class? My go-to-guy when the world starts spinning off its axis? The second thing you wonder about is how to get more granular about our $3.6 trillion housing market. Where exactly should you invest?

If anyone tells you with confidence what is going to happen over the next year or so, you should probably switch off. Nobody can forecast our chaotic and complex futures over the long run. The best you can do is plan for a range of contingencies.

I find it helpful to conceive of two extremes. The first involves deflation, global recession, and ultra-low interest rates. The second is a world that has some growth coupled with rampant inflation and, eventually, stonking interest rates.

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Put a gun to my head and I’d speculate that all roads ultimately lead to inflation. Most developed counties are wilting under the weight of ballooning public and private debt burdens. The quickest ways to reduce debt are to default or to allow inflation to chisel away at the fixed dollar value of your obligations.

The inflationary path is superficially more palatable. It is less destabilising in the short run and allows you to leave rates comfortably low for a time. Everything looks peachy until you end up having to cauterise spiralling inflation with destructively steep rates. The Bundesbank understands this endgame, which is why it advocates fronting up to austerity now instead of kicking the can down the road.

Unsurprisingly, myopic politicians have opted for Easy Street. Increasingly non-independent central banks are running near-zero interest rates with the aim of stoking inflation. Over-the-horizon problems are not on their radar screens.

They are printing trillions of new dollars to buy government and corporate debts, and to lend directly to banks, to artificially suppress rates.

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People forget that central bank balance sheets have to balance. So the new assets they create by printing money must be matched by new liabilities. Overall taxpayer indebtedness is mounting.

Central banks have no magic wand with which to disappear debt. It is being passed from one hand to the next with the hope inflation will cause it to atrophy.

At call, variable rate cash assets are the Humvee of all investments. If the global economy endures an acute recession and deflation, cash preserves the value of your capital and offers the prospect of decent real or deflation-adjusted returns. If and when robust inflation starts materialising, we are in the fortunate position of having a central bank that explicitly targets consumer prices with its official rate.

In Australia, if not in other countries, high inflation leads to high short-term cash rates. Recall that in January 1990 you could earn 17 per cent on a bank deposit.

Crunching the past 22 years of numbers, I’ve found the correlation between the Reserve Bank of Australia’s cash rate and core inflation in Australia is a strong 60-70 per cent. After deducting inflation, the RBA’s cash rate gave you an average annual real return of about 3 per cent, which is what most super funds seek.

A word of warning on fixed-income, though. Fixed-rate bonds expose you to the risk of capital loss if interest rates rise. This is why there is a popular perception that bonds are bad inflation hedges. Even in Australia, longer-term yields on fixed-rate bonds are at historically low levels. Funds that hold these assets could suffer substantial losses if rates start rising again. Variable-rate cash investments do not carry this duration risk. The returns these assets produce move in sympathy with the RBA’s rate with no changes in the capital value of your investment.

What about your second question? Today housing is an extremely interest-rate sensitive sector. While Australia’s household debt-to-disposable income ratio has not risen for six years, it remains at elevated heights. So one needs to be mindful of market timing.

In good news for property investors, the RBA now has an easing bias. Indeed, it is toying with the idea of shaving rates again before the year is out. Taking these facts as given, where should you put your money?

Since the end of the last housing boom in 2003, Sydney dwellings have provided staggeringly low annual capital gains of just 1.9 per cent (that is, they’ve declined in both inflation- and income-adjusted terms).

In comparison, Melbourne homes have done nearly three times better furnishing annual capital growth of 5.5 per cent. A trade-off of superior asset price appreciation has been weaker yields. Whereas Sydney apartments today offer gross rental yields of 4.9 per cent, you only get 4.4 per cent in Melbourne.

Crucially, however, these long-standing dynamics have started to reverse. In the past nine months, Sydney prices have outperformed all other major cities with 2 per cent growth. In contrast, Melbourne home values have contracted by a similar margin while the national market has moved sideways.

To inject more detail into this picture, I asked Rismark to identify the best and worst-performing suburbs across Australia’s cities over the last year.

Suburbs in west and south-west Sydney, and the Fairfield-Liverpool regions, have been top of the pops with capital gains of between 5 per cent and 8 per cent.

This is a notable turnaround: for many years housing in south-west Sydney was the perennial dog.

Australia’s worst-performing suburbs have been those located in south and inner Melbourne, where home values have slumped by 8 per cent to 10 per cent.

Our research shows that past housing performance tends to persist for several years. Accordingly, when looking for assets, you should carefully quantify recent rates of return.